Chapter 1 Financial Statements Overview PDF

**[Chapter 1: Financial Statements: An Overview]** **Learning Objectives:** - Explain why and how financial statements are useful for decision making - Describe the organizations that govern accounting rulemaking - Describe the components of a Form 10-K - Explain the challenges and...

**[Chapter 1: Financial Statements: An Overview]** **Learning Objectives:** - Explain why and how financial statements are useful for decision making - Describe the organizations that govern accounting rulemaking - Describe the components of a Form 10-K - Explain the challenges and complexities inherent in the accounting rules - Understand management's impact on the quality of financial reporting 1. **Map of Maze** 1. As a **[map],** financial statements form the basis for understanding the financial position of a business firm and for assessing its historical and prospective financial performance 2. A **[maze]** attempts to confuse its user by purposefully introducing conflicting elements and complexities that prevent reaching the desired goals. 3. The complexity of accounting policies underlying the preparation of financial statements can lead to confusion and variations in the quality of information presented a. Rules are constantly **[evolving and changing].** b. **[Management discretion]** in a number of areas influences financial statement content and presentation in ways that affect and impede evaluation. 4. Financial statements as a ***map***: c. Form the basis for understanding the **[financial position]** of a firm d. Allow users to assess historical and prospective financial performance e. Present clear representations of a firm's **[financial health]** 5. Financial statements as a ***maze***: f. Overwhelming amount of information g. Unreliable auditing h. **[Complex policies]** and reporting requirements i. Considerable **[discretion]** given to management j. Key information hidden or omitted 2. ***Usefulness*** 1. The objective of the financial statement user is to find and interpret this information to answer questions about the company, such as the following: a. Would an **[investment]** generate attractive returns? b. What is the degree of **[risk]** inherent in the investment? c. Should existing investment holding be **[liquidated]**? d. Will cash flows be sufficient to service **[interest]** and **[principal]** payments to support the firm's borrowing needs? e. Does the company provide a good opportunity for employment, future advancement and employee benefits? f. How well does this company compete in its **[operating environment]**? g. Is this firm a good prospect as a customer? 2. The **[Securities and Exchange Commission (SEC)]** requires large, publicly held companies to file this annual report h. The annual report is used by: i. Shareholders ii. General public iii. Regulators iv. Analysts v. Researchers 3. Annual report and **[10-K]** report generally contain the same information. This basic set of information includes: i. Financial statements j. Notes to the financial statements k. **[Required supplementary data]** 4. The information in the financial statements is used to help interested parties evaluate: l. Financial position of the company m. Success of operations n. Policies and strategies of management o. Provide insight into future performance. 3. ***Volume of Information*** 1. The users of a firm's annual report can expect to encounter a great quantity of information that encompasses the required information: a. Financial statements b. Notes to the financial statements c. The auditor's report d. Management's discussion and analysis of operations e. Material that is included in the report at the imagination and discretion of management 2. Financial statements are prepared in accordance with **[generally accepted accounting principles (GAAP)]** f. In order to present financial information that is **[understandable]** by users as well as **[relevant and reliable]** for decision making 3. Two primary authorities responsible for establishing GAAP in the US g. SEC -- a public-sector organization h. **[Financial Accounting Standards Board (FASB]**) -- a private-sector organization 4. Required SEC fillings: i. Annual Report (10-K) j. Quarterly Report (10-Q) k. Other reports dependent on particular circumstances (8-K) 5. Three primary goals of the FASB l. 1\) simplify user access by codifying in one source all authoritative GAAP in the US m. 2\) ensure that the codified content accurately represents authoritative US GAAP n. 3\) create a codification research system that is up to date for the released results of standard-setting activity 6. FASB/SEC relationship o. SEC has congressional authority to set accounting policies, however, for the most part, accounting rule making as been delegated to the FASB p. SEC steps in to take action when specific circumstances warrant penalties, especially in situations involving accounting fraud A diagram of a accounting rules Description automatically generated 4. ***Global Economy*** 1. The globalization of business activity has resulted in the need for a uniform set of accounting rules in all countries a. **[International Accounting Standards Board (IASB)]** -- the international organization responsible for establishing accounting standards and promoting worldwide acceptance of those standards i. **[International financial reporting standards (IFRS)]** -- the accounting standards established by IASB 2. SEC has supported global accounting standards in principle but requires US companies to follow **[GAAP]** 5. ***Where to find a Company's Financial Statements*** 1. **[10-K]** -- required to be filed annual with the SEC for all publicly traded companies in the US a. All companies follow the organization of statements (i.e., the same order) 2. **[Annual Report]** -- publicly traded companies are required to provide to shareholders prior to a firm's annual shareholder meeting b. Contains: Financial statements and public relations material 3. **[Corporate Website]** -- includes additional information on the company, such as a letter to the shareholders, a statements of the company's vision and colorful pictures showing consumers enjoying the firm's products. 6. ***The Financial Statements*** 1. Annual report contains four basic financial statements a. **[Balance sheet (or statement of financial position)]** shows the financial position -- assets, liabilities, and stockholders' equity -- of the firm on a particular date b. **[Income statement (or earnings statement)]** presents the results of operations -- revenues, expenses, net profit or loss, and net profit or loss per share -- for the accounting period i. **[Statement of comprehensive income]** -- presents the changes in equity of a company during a period from transactions, other events and circumstances related to nonowner sources 1. Included immediately following the income statement c. **[Statement of stockholders' equity]** reconciles the beginning and ending balances of all accounts that appear in the stockholders' equity section of the balance sheet d. **[Statement of cash flows]** provides information about the cash inflows and outflows from operation, financing, and investing activities during an accounting period 7. ***Notes to the Financial Statements*** 1. Included immediately **[following]** the four financial statements and are an integral part of the statements 2. Provides a summary of the firm's accounting policies 3. Contains details about particular accounts 4. Include other supplementary information 8. ***Auditor's Report*** 1. **[Management]** is responsible for preparation of the financial statements, including notes 2. **[Auditor's]** report attests to the fairness of the presentation of the financial statements 3. **[Sarbanes-Oxley Act]** of 2002, Section 404 requires that an **[internal control]** report be added to the annual report a. Law requires companies to include in their annual report a statement regarding the **[effectiveness]** of internal controls and the disclosure of any **[material weaknesses]** in a firm's internal control system 4. **[Internal Controls]** -- policies and practices a company puts into place to protect the integrity of its assets and financial and accounting information, promote accountability and prevent fraud 5. Types of Audit reports b. **[Unqualified report]** -- states that the financial statements are presented fairly, in all material respects, in accordance with GAAP. c. **[Qualified report]** -- opinion rendered when the overall financial statements are fairly presented "except for" certain items, items are disclosed in the report i. The result of a departure from GAAP d. **[Adverse opinion]** -- states that the financial statements have not been presented fairly in accordance with GAAP e. **[Disclaimer of opinion]** -- issued when the independent auditor could not evaluate the fairness of the financial statements and, as a result, expresses no opinion on them ii. Scope limitation -- the extent of the audit work has been limited iii. Lack of independence f. Unqualified opinion with **[explanatory language]** -- states that the financial statements have been presented fairly in accordance with GAAP, but there are items which the auditors wishes to explain to the user 6. Changes to the auditor's report (2019) g. Auditor's report moved to the first part of the report h. Added more titles i. Disclosing the responsibility of management and auditors for issues related to going concern j. Introduced key audit matters k. Expanding disclosure of auditors responsibilities 9. ***Financial Reporting Reforms*** 1. Prior to SOX, auditors followed a self-regulatory model 2. SOX Title I established the **[Public Company Accounting Oversight Board (PCAOB)]** -- a private, nonprofit organization that has been given the authority to register, inspect and discipline auditors a. Has the authority to write auditing rules and set quality control and ethics standards 3. SOX Title II addresses areas of auditor independence b. Prohibiting certain **[non-audit]** services when conducting an external audit of a firm c. Requires the rotation of the primary audit partners every **[five years]** d. Implemented a one-year waiting period before an employee from the external audit firm may serve in **[key positions ]** 4. SOX Title III and IV focus on corporate responsibility e. Section 302 requires that the **[CEO and CFO]** of a publicly owned company certify to the **[accuracy]** of the financial statements. 5. SOX Title IX attaches harsher penalties for violations f. Section 906 addresses **[criminal penalties]** for certifying a misleading or fraudulent financial report g. Section 302 and 906 work together with section 404 to encourage CEOs and CFOs to take responsibility for strong internal controls to **prevent [accounting fraud] and financial statement [misrepresentation]**. 10. ***Management Discussion and Analysis*** 1. **[Management Discussion and Analysis (MD&A)]** contains information that cannot be found in the financial data 2. Incudes coverage of trends and significant events or uncertainties in liquidity, capital resources, and the results of operations 3. 2020 Amendments: a. Added new item intended to clarify the purpose of MD&A disclosures b. Required disclosure of critical accounting estimates 11. ***Pandora (a.k.a. "PR Fluff)*** 1. "**[Other information]**" included on a company's website (i.e., colored photographs, charts, shareholders' letter from the CEO, etc.) 2. Often informative but sometimes misleading 12. ***Proxy Statements*** 1. Used to solicit **[shareholders']** votes 2. Important in assessing who manages the firm, how management is paid and conflict-of-interest issues 13. ***Missing and Hard-to-Find Information*** 1. Some of the facts needed to evaluate a company are not available in the financial statements. 14. ***Characteristics, Assumptions, Principles, and Basis of accounting*** 1. **[Materiality]** -- refers to the fact that the dollar amount of the information must be significant enough to make a difference in decision making 2. **[Comparability]** -- allows users to compare the financial information of an entity to other entities as well as compare financial information of that entity to itself from one time period to another 3. **[Consistency]** --the same accounting methods and choices should be used from one time period to another 4. **[Going Concern Assumption]** -- assumes that business entities will operate indefinitely unless there is strong evidence to the contrary 5. **[Time Period Assumption]** -- indicates a specified time period that business firms use to report financial information 6. **[Monetary Unit Assumption]** -- is the assumed unit of measurement when preparing financial statements 7. **[Revenue Recognition Principle]** -- four conditions must be met in order to record revenue: i. the revenues must be **[earned]** ii. the amount of revenue must be **[measurable]** iii. the **[cost]** of generating the revenues can be determined iv. the revenue must be **[realizable]** a. Determined with a five-step framework v. identify the **[contract]** with a customer vi. identify the **[performance obligations (objectives]**) in the contract vii. determine the contract **[price]** viii. allocate the transaction price ix. recognize revenue when or as the entity **[satisfies a performance obligation]** 8. **[Matching Principle]** -- requires revenues and expenses to be properly matched in the same time period 9. **[Accrual Basis of Accounting]** -- accounting basis used for the reporting of GAAP based financial statements; Based on both the revenue recognition and the matching principles. a. **[Revenue]** is recognized in the accounting period when the sale is made rather than when the cash is received b. **[Expenses]** are recognized in the period incurred rather than when cash is paid. 10. **[Cash Basis of Accounting]** -- recognizes revenues when cash is received and recognizes expenses when cash is paid 1. **Complexities and the Quality of Financial Reporting** 1. GAAP provides a measure of uniformity but also allows corporate management considerable **[discretion]** in applying the regulations 2. Financial statements should reflect an accurate picture of a company\'s financial **[condition]** and **[performance]** ***1.2.1 Accounting Choices*** 1. Management discretion in application of reporting regulations 2. Differing **[accounting methods]** impact comparability of companies (i.e., inventory valuation method) a. **[Quality]** of financial reporting can be impacted if the accounting choice does not reflect economic reality 3. Financial statements are prepared on certain dates at the end of accounting periods b. Firm's life is **[continuous]** c. Financial data must be appropriated to particular time periods. ***1.2.2 Timing of Revenue and Expense Recognition*** 1. GAAP principle that provides the foundation for preparing financial statements is the **[matching principle]** a. **[Expenses]** are matched with the generation of **[revenues]** to determine net income for an accounting period 2. Accrual basis of accounting b. Recognize revenues when **[earned]** c. Recognize expenses when **[incurred]** d. Recognizes revenues and expenses independent of **[cash inflows]** and **[outflows]** e. Involves judgements by management on **[timing]** i. The more conservative management is in making such judgments the higher the quality of earnings ***1.2.3 Discretionary Items*** 1. Revenues and expenses under that control of management with respect to **[budget levels and timing ]** 2. Management choices have an immediate and long-term impact on **[profitability]** 3. Financial analyst should scrutinize management's policies regarding discretionary items